For E.T.F. Traders, Lessons From the Panic

Image

A sudden fall in prices on Aug. 24 activated circuit breakers on the New York Stock Exchange, affecting stocks from a wide range of companies, like CVS and Ford. Halts to trading in those underlying shares also had an unexpected impact on exchange-traded funds.CreditCreditChristian Hansen for The New York Times

By Conrad De Aenlle

Jan. 15, 2016

A selling point of exchange-traded funds over traditional mutual funds is that they can be traded at any time during a market session, but when stocks plunged as soon as trading began on Aug. 24 — that feature of E.T.F.s became a bug.

Investors found that while they could continue to trade E.T.F.s, so many shareholders wanted to bail out simultaneously that prices on many funds fell well below the sharply falling values of their underlying stock portfolios.

Other E.T.F.s were down far more. Guggenheim S.&P. 500 Equal Weight, for example, fell as much as 43 percent, while iShares Select Dividend dropped as much as 35 percent.

What happened, fund specialists say, is that many of the constituent stocks in the S.&P. 500 and other indexes could not open during the panic because circuit breakers were activated on the New York Stock Exchange that halted trading in those stocks. The affected issues represented all walks of corporate life, from Ford to CVS to Service Corporation International, the nation’s largest owner of funeral homes.

Although halts affected some E.T.F.s that tracked stock indexes, any E.T.F. that continued to trade or had resumed trading used lowball price estimates for any index components that were halted.

Post-mortems indicate many of the causes of the problems, but suggest that the short-term solution for many investors may simply be greater wariness.

Short-term trading of E.T.F.s has some hidden dangers that may not be remedied immediately. Some problems may stem from the overall markets, some from the structure of E.T.F.s themselves.

In a report examining trading on Aug. 24, for example, BlackRock, the world’s largest fund management company and owner of the iShares E.T.F. brand, attributed the outsize declines in stock E.T.F.s partly to a flood of market and stop orders. Market orders are filled at the prevailing price, even during disorderly trading; in stop orders, a stock is sold if the price falls to a level set by the seller.

Along with the trading halts that left E.T.F. market makers unable to determine fair prices, these orders “added to selling pressure and proved especially risky on the morning of Aug. 24,” the BlackRock report said. A report issued by Vanguard highlighted the same culprits.

The Securities and Exchange Commission has proposed no new rules nor taken other action in response to the E.T.F. pricing discrepancies. The New York Stock Exchange announced that stop orders on stocks would no longer be accepted beginning on Feb. 26, and it widened the price moves needed to prompt a trading halt.

Stop orders were already not allowed on the exchange’s Arca market, where E.T.F.s are listed. But E.T.F.s also trade on other markets, where some brokerage firms execute stop orders on them (they do so by placing a market order when the stop price is hit). The status quo is murky, but maintaining a semblance of it for E.T.F. trading may be the best move for now, some investors say. They worry that any cure will be worse than the affliction.

“When I look at what took place, it leaves me perplexed,” said Philip Blancato, chief executive of Ladenburg Thalmann Asset Management, a firm that builds portfolios for financial advisers and rich investors. “If more safeguards are put in, it may be even harder in a panic situation to trade E.T.F.s. If I’m not able to control my own destiny and get in and out of the market, that’s extremely concerning.”

But he’s not against the idea of certain restrictions, including limiting sales early or late in a trading session through market and stop-loss orders. It might be reasonable, Mr. Blancato said, to limit trading when an E.T.F. moves 1 percent above or below its intrinsic value, or if trading volume reaches a given proportion of the number of shares outstanding.

Vanguard anticipates “enhancements to the existing rules” governing trading in general, not E.T.F.s specifically. In its report, it contends essentially that the market failed E.T.F.s rather than the other way around.

Todd Rosenbluth, director of fund research at S&P Capital IQ, part of Standard & Poor’s, came to a similar conclusion. “This is a problem in the market that E.T.F.s got caught up in,” he said. “They weren’t the cause.”

The BlackRock report recommended several steps to avoid a repeat performance, including greater efforts by exchanges to maintain trading in securities rather than limit E.T.F. trading, and measures to encourage E.T.F. market makers to play a more active role during stressful periods.

“I’m not sure anything gets done,” he said. “E.T.F.s are still a small piece of what investors trade, so I don’t think much will change.”

The discounts during the plunge were an egregious example of E.T.F. pricing discrepancies, but hardly the only one. Tim Clift, chief investment strategist at Envestnet/PMC, another firm that uses E.T.F.s to build portfolios for third parties, said that mispricing “is not just an Aug. 24 thing.” Modest deviations from net asset values occur often, he said, especially in funds that invest in less frequently traded niches like high-yield bonds and foreign stocks.

High-yield bond E.T.F.s can be particularly problematic, Mr. Clift said, because bonds in the indexes they track might not trade for days. That makes it difficult to know the true value of the bonds, and the E.T.F. issuers must therefore rely on services that determine prices for illiquid bonds based on corporate and market developments.

To complicate matters further, E.T.F.s are inclined not to own bonds that trade irregularly; instead, they hold portfolios of more liquid issues that they expect to correlate highly — but not perfectly — with a relevant index. That also creates pricing distortions.

The chronic mispricings in bond E.T.F.s are minor compared with the ones that stock E.T.F.s experienced on Aug. 24. But a shocking event, such as an unforeseen increase in interest rates, could change that, Mr. Blancato warned.

“If we get a rate rise and there’s panic selling in the bond market, you’ll see prices gap down 8, 10, 20 percent,” he predicted. Bond mutual funds would be hit too, he added, but professional managers would be less inclined to engage in knee-jerk selling, and shareholders would be somewhat insulated because mutual fund shares are redeemed at face value, with no premium or discount.

With the difficulties of Aug. 24 in mind, small investors may want to adjust the way they trade E.T.F.s. Mr. Blancato recommended avoiding ones in niches where the underlying instruments trade infrequently, like hedge fund strategies, private equity and floating-rate notes, a type of debt whose interest payments change when market rates rise or fall.

Mr. Rosenbluth is concerned less with what investors buy than with how they buy it. “You don’t want to buy or sell at the open or close when there’s a lack of clarity in the market and you won’t get a fair price for your efforts,” he said.

He encouraged investors to stick to the basics and use E.T.F.s to meet long-term goals. They may trade all day long, but you are not required to do the same.

“Having access to trading doesn’t mean you should trade or that you’ll make the right decisions,” Mr. Rosenbluth said. “The benefits of E.T.F.s outweigh the drawbacks, but people should go in with their eyes open and be aware that there are challenges.”

A version of this article appears in print on , on Page BU14 of the New York edition with the headline: For E.T.F. Traders, Lessons From the Panic. Order Reprints | Today’s Paper | Subscribe